Monday, April 8, 2013

I'm seeing more and more observers commenting on the apparent disconnect between the stock and bond markets. Reader "Rob" recently linked to a post by Thomas Kee at Smart Money that is typical. Kee argues that bond buyers these days are likely smarter than equity investors, because "they are educated and intelligent, and they make decisions for longer-term purposes." Whereas equity investors are more short-term focused ("fast money") and currently have been lulled into believing the recovery is real, when in fact it is "fabricated."

I think it's very difficult to defend the belief that one class of investors (bond buyers) see the world differently than another class (equity buyers), when both operate in the same capital market and both have access to the same information. To assert this, however, I need to show how it is that bond and equity investors today share similar beliefs about the economic fundamentals. If I'm right, then the "disconnect" is not really a disconnect, it's simply the result of how two very different asset classes react to the same information.

The chart above is a good illustration of the alleged "disconnect" between the stock and bond markets. Over the past three years, stock prices have been in a rising trend, while bond yields have been in a falling trend. That doesn't make sense, so the thinking goes, because falling bond yields are symptomatic of a market that is increasingly risk-averse, whereas rising equity prices are symptomatic of a market that is increasingly risk-loving. I think both interpretations are wrong.

As the first chart above shows, there is a decent correlation between the level of real yields and the strength of the economy. Real yields and real economic growth were both quite high in the late 1990s and early 2000s. The economy had been booming for several years, and the market expected this to continue. The real yield on TIPS had to compete with the very strong real yields on equities. This makes perfect sense. Now, over a decade later, real yields on TIPS are negative and the economy is in the midst of its weakest recovery ever, with a so-called "output gap" that could be as much as 13%. As the second chart shows, consumer confidence is extremely low; although it has risen in recent years, it is still at levels that in the past have coincided with recessions. The first chart suggests that the level of real yields is consistent with market expectations of almost zero growth for the next several years.

As the chart above shows, the equity risk premium—defined here as the difference between the earnings yield on equities minus the yield on 10-yr Treasuries—is extremely high. Why would the market be indifferent between an almost 5% earnings yield on equities and a paltry 1.7% yield on 10-yr Treasuries? The only explanation that makes sense is that the market has almost no confidence that corporate profits will maintain their current levels; instead, the market fully expects profits to decline significantly.

As the chart above shows, the earnings yield on equities tends to track inversely the real yield on TIPS. In other words, when real yields fall, as they have over the past decade, the earnings yield on equities has risen. The more gloomy the market becomes over the prospects for economic growth, the higher the equity yield that the market demands in compensation for what is expected to be a big decline in profits. The two lines have diverged of late, and perhaps that is significant, but such divergences have happened before.

As the chart above shows, it is very unusual for the earnings yield on equities to be higher than the yield on BAA corporate bonds. Would you pass up the opportunity to buy stocks with a higher earnings yield than available on corporate bonds if you thought the economy was going to be healthy? No, because that would mean giving up the opportunity for price appreciation. Investors today are willing to accept a lower yield on corporate bonds because bonds are higher in the capital structure and have first claim to earnings, which the market suspects may be in for trouble.

But what about the fact that stock prices are at all-time highs? Doesn't that conflict with the fact that Treasury yields are close to all-time lows? Not necessarily. As the chart above shows, in inflation-adjusted terms the S&P 500 is still almost 25% below its 2000 all-time high. From a long-term perspective, the chart suggests that current equity prices are about "average," having followed a 3% trend growth rate, which happens to be the average real growth rate of the U.S. economy. Moreover, corporate profits today are almost 200% above the levels of late 2000. By these metrics, stocks are not optimistically priced at all. Today's S&P 500 PE ratio is just above 15, which is below its long-term average of 16. Shouldn't PE ratios be much higher than average considering that risk-free discount rates are at all-time lows?

Bonds and stocks are both priced to pessimistic assumptions about the future health of the U.S. economy, no matter how you look at it. And as for the assertion that the recovery has been "fabricated," I refer the reader back to many of my posts which show abundant evidence that many sectors of the economy are posting solid, undeniable growth, beginning with this recent post. This recovery may be the weakest ever, but it is no less real because of it.

27 comments:

Global investors have been storming out of the yen for months in anticipation of last week's move by the Bank of Japan, bringing the currency's decline to 29% against the dollar since late September.

"It's evident that Japanese flow into foreign fixed income has picked up" since the Bank of Japan's decision on Thursday, said Jens Nordvig, head of major-currency strategy in New York for Nomura Securities. Mr. Nordvig said recent transactions made by Nomura's big Japanese clients show an increase. "This is a historical shift that investors are trying to position themselves for," Mr. Nordvig said.

Over the past two trading days, France, the Netherlands, Austria and Belgium saw their borrowing costs, as indicated by 10-year bond yields, fall to record lows.

Scott, I want to thank you again for all the effort which you make on your readers behalf to provide us with your excellent, experienced economic and market analysis.

In light of WSJ article above,the most striking chart is the first one which shows that the 30 year US Treasury bond fell precipitously in mid-2011 and made only a feeble recovery afterwards. That is when the S&P 500 and US bonds parted ways. So it might be worth pondering what changed so dramatically in mid-2011 and persists today?

I can think of these: 1) the true seriousness of the European Union and EURO crisis became real, 2) the economic stimulus programs of major economies ran out, 3) it became apparent that China was not returning to 9+ % growth, 4) England's austerity measures would result in recession, 5) Japan would not return to positive growth of any significance and 6) emerging markets would not lead global growth.

Most of these realities are not US centric but rather foreign. Could it be that the 2011 dramatic fall in US bond rates which persisted is due largely to unusual demand for US bonds by foreigners?

The recent decline in US 10 year yields from over 2% to 1.7% seemed to coincide with the Cyprus debt problem and the change in Japanese central bank policies.

The big decline in yields in mid-2011 was all about the Eurozone debt crisis, with the S&P downgrade adding to concerns. The Eurozone has been in recession for almost two years now, with little hope yet for a recovery, and that contributes to the market's sense that the U.S. economy will have very tough sledding in the years to come. Cyprus so far has been a very minor crisis. Stocks have rallied because they have been priced to a recession that just doesn't happen. Stocks are up because today's reality, while not very optimistic, is better than the market had feared.

Folks, the bond market is not pretty -- consider 10-year Treasuries (!) as only one ominous sign for the future -- my advice is to brace for a crash landing -- the good news is that crashes create buying opportunities -- investors with world-class skills (e.g., surgeons, movie stars, pop singers, professional athletes, etc) will be able to convert cash into cheap equities like never before -- I cannot over impress upon investors the importance of obtaining world-class skills that convert into premium earnings used to acquire vast portfolios of dividend and rent-earning equities -- accredited investors with 30-year investment horizons will be the big winners once the crash hits -- everyone else (people earning less than $300,000 annually) will be wiped out by unemployment, divorces, crime, and taxes -- today's realities are so very clear at this point -- this is going to be bloodbath...

Scott I second William's thanks for your great work ! I also wonder whether, just as globalization has changed the earnings ability of US companies, so it is also globalization that is now feeding the bond bull market, with foreign buyers seeing US Treasuries as the only safe port in a storm of protracted uncertainty ??

Scott, your posts are always thought provoking, this one no exception. Your main takeaway from this analysis of investor sentiment in the bond and stock market seems to be that investors remain extremely pessimistic about the future. Your view seems to be that things are gradually getting better hence there is a great opportunity still in equities. But I wonder if your measure of the equity risk premium is not overstated by the crazy distortions in the bond market. You agree that negative real yields dont make any sense. So if you were to subtract the earnings yield on equities from a 10-year yield that you thought was more rational, what would your conclusion be about value and sentiment. Thanks again for sharing your curiosity with your readers.

Scott perfectly demonstrates the thinking of the average equity investor, rejoicing about minuscule GDP growth, completely ignoring the increase in debt necessary to produce this little growth.That's same as a company whose debt is increasing at 10% a year, but having only 0.4% sales growth to show for. While bond investors look at the entire balance sheet, equity investors are myopically focused only on what effectively is merely a "left-over" once debt is subtracted from assets.

I can't find any signs in the bond market that Treasury yields are distorted or artificially depressed. I don't believe the Fed can artificially depress Treasury yields when it only holds a relatively small fraction of outstanding Treasuries.

Hi Scott. I don't think that the Fed has had much influence either. My thought was that the equity risk premium probably if it was based on a level of bond yields more in line with the pace of growth in the economy. If nominal GDP is expanding at 4-5%, then 10-year yields below 2% dont make a lot of sense. Could be a lot of things...depressed conditions out of Europe, Japan etc. But subtracting a yield more in line with nominal GDP would give you a different impression on the risk premium.

Francis: I don't think it helps to assume that Treasury yields should be higher. They are what they are. Moreover, the equity premium stands out as very high, PE ratios are somewhat below average, and the earnings yield on equities is quite a bit above the yield on corporate bonds. All of that combines to say that equities are priced to pessimistic assumptions. We are not in normal times, when 10-yr Treasuries would undoubtedly yield substantially more.

LOL... why then do you think the Bernank is spending a cool trillion a year? For nothing?

Scott, you should know that prices are determined at the margin. In the 20-30 year bucket the Fed is buying 60% (TIPS) to 91% (T-Bonds) of net issuance. Please don't try to tell me that this is not total price dominance. You are losing credibility, fast.

The price of large asset classes is not determined by the marginal buyer of new issuance. It is determined by the willingness of the market to hold the outstanding stock of that asset. In any event, the Fed only owns about 16% of marketable Treasury debt, and that is less than the 20% it owned 13 years ago.

The world's biggest bond fund manager Bill Gross has had a change of heart on Treasurys, raising allocations to U.S.government bonds, as the fund sought to pre-empt an increase in buying from Japanese investors.

"This BOJ printing seeps out daily into global markets as Japanese institutions which have sold their Japanese government bonds to the BOJ look for higher yielding replacements," he told The Wall Street Journal on Tuesday. "Ten-year Treasurys to us look very low-yielding,but to them they yield 125 basis points more," he added.

In reading major institutions' predictions and asset allocation recommendations for 2013, I didn't fine even one recommendation for increasing bond assets - most warned of the danger of US bond yields rising. US banks and brokerages are negative on US bonds.

Therefore I think that it must be global institutions and investors who find US bonds safe and their yields attractive - like Gross thinks the Japanese will.

Gloeschi, it you you who is losing this and virtually every other argument. I understand being realistic Vs optimistic but you incessantly harangue with the pessimist outlook that offers no value to this forum. thankfully, I suspect most readers embrace a more balanced perspective. otherwise we'd be sitting on the sideline earning negative real returns.

I've been on panel discussions with Jim Paulsen several times over the years, and he always struck me as a sensible person and a very good analyst/economist. The article linked to above agrees very much with how I see things.

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